Daniel Dobbins Distillery, Inc Case Solution

1. Is Dobbins using LIFO or FIFO? Which should it use?

Evaluation of Dobbins financial statement shows that Dobbins is currently using LIFO, Last In First Out method. As production manager of Dobbins, James Doud mentioned that due to increase in production by 50% this year, the costs are bound to increase. It means that the costs, which are directly and indirectly attributable to new whiskey, are included in the income statement as a part of other costs. The direct costs of new bourbon are inventoriable costs, which must be capitalized. However, these costs are added in the income statement as a part of cost of goods sold. This clearly shows that method of accounting used by the Dobbins is LIFO.

The income statement, which resulted under LIFO method, shows negative net income, consequently, leaving little chance for the company to borrow $3 million from Ridgeview National Bank of Nashville, Tennessee.

On the basis of the production procedure along with aging, it is suggested that Daniel Dobbins Distillery should use FIFO method. The net income would be highly under-valued under the LIFO accounting method. In FIFO method of accounting, all the costs, which are traceable to new whiskey, are included in inventory. FIFO method would result in high net income and high level of operating assets for Dobbins.

2. Please provide a FCFF and Intrinsic Firm Value for Dobbins:

A. as if it had not increased production;

Free Cash Flow to the Firm is calculated under two different scenarios. In the first scenario, it is assumed that production had not increased. Hence the cost of barrel, $63 per barrel, would not change in coming years from 1988 to 1991. Similarly, all costs under the section of “other cost” would not change, such as, occupancy cost, warehouse labor cost and depreciation of warehouse equipment and etc. As a result of similar cost of goods sold; the projected net income would remain similar for next four years. The effect on the balance sheet in case of the same production would be positive, under current accounting method being used. Project amount of cash would keep rising. Operating current assets remains same due to same projected revenues in coming years. There is same increase in current liabilities during next years. The projected free cash flow rises from $1,606,000 to $2,606,000 till the last year. Firm value for Dobbins is calculated by adding present values of all free cash flows to the excess cash. The interest rate is assumed to be 10 percent while finding out the present values. The firm value in case of similar production comes out to be $25,232,000.

B. Given its increases in production.

Second scenario, in which firm increases its production, shows less projected income and lower projected cash for the future. The reason behind negative projected income is a large increase in “other costs”. In the ‘other cost’ section, there is an increase in cost of barrel, occupancy cost, and cost of warehouse labor and depreciation of warehouse equipment. This negative net income causes negative projected free cash flows of the firm; as a result, firm value of Dobbins lowers down. Intrinsic value of the firm, calculated as above mentioned procedure, comes out to be $475,000. The reason of unusually low free cash flows and value in the second scenarios are that the increased costs, which can be directly traced into increased production, are added in current years. However, the firm would obtain high revenues for four years after production has increased.

3. In your opinion, what costs should be included in Dobbins's inventory?

The income statement of Daniel Dobbins Distillery, Inc is showing a negative net income of $814,000. This low net income could be a hurdle for the company of in obtaining $3 million loan from the bank for additional capital. The increased production in 1988 has caused unusually low level of net income, and the revenue directly related to this increased production would benefit the firm after four years. Whether the costs related to increased production should be added in this period in the income statement or the period in which revenues are earned, is the question. Under the current accounting method, all the costs are added into current income statement under the section of other cost. This large increase in cost without revenues being increased caused a massive blow to company’s income statement. To overcome this condition caused by inappropriate method of accounting, it is suggested that all the costs that are direct costs for increased production and can be directly traced to the 50% increase in production should be included in Dobbin’s inventory.

Barrel costs i.e. more than 60 per barrel is the direct cost that can easily be traced into the increased production cost should be included in inventory. High net income and high inventory would be the result of this aging cost in inventory.

Aging is a highly necessary phenomenon in making a final product. Hence its cost cannot be considered as an indirect cost. In order to facilitate aging for increased production; Dobbins rented an aging warehouse at an annual rental cost of $200,000. Moreover, to control the temperature and humidity of the warehouse space, Dobbins incurs the cost for the warehouse labor and supervisor.

All these costs, including barrel cost, warehouse rental cost and warehouse labor costs are directly attributable to the increased production. Hence these costs must be included in inventory in year 1988.

Also, there is an increase in selling, advertising, administration and general expenses due to higher production in year 1988. However, these costs are indirect and cannot be traced directly into new bourbon. The Darlene argument of capitalizing everything, the salaries expenses and advertisement expenses, is flawed. As these costs are not considered to be the direct cost, so they cannot be capitalized.